Oil Likely to Remain at $50, But Don't Celebrate Yet

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Oil prices are expected to stay around $50 a barrel through next year, say analysts, though that may not give much of a boost to consumer spending, the economy and stock market.

That’s because the the 60 to 70 percent plunge in oil prices since July is due to the collapse of demand as the credit crisis careens through the global economy. So whatever benefits lower oil prices normally bring is more than offset by the profound weakness in the economy.

“The negative wealth effect [among households] is far outweighing any benefit that lower gas price is having on discretionary spending," said Chris Hyzy, chief investment officer for U.S. Trust, the private wealth management unit of Bank of America (NYSE: BAC). "And we will not feel the positive effects of that until at least the second half of ‘09.”

Hyzy added that “contrary to prior cycles”—when lower oil prices were deemed good for stocks—falling prices are actually “having a negative spiral effect” by signaling a bottom has not yet been reached.

Even so, the savings to consumers is still substantial.

Every 10 cent drop in the price of gasoline is the equivalent of a $12 billion tax cut, calculates Nariman Behravesh, chief economist with IHS Global Insight, the forecasting firm.

“So the drop from around $4 a gallon to less than $2 is the equivalent of a $250 billion tax cut, more or less,” he said.

That is offering some limited relief.

“A lot of consumers had to squeeze other kinds of spending just to be able to pay their gasoline bills, now they don’t have to do that any more or not nearly as much,” said Behravesh. “But this is not enough to counter all the other heads winds that are out there.”

And the relief is also relative. Tom Kloza, the gas guru at Oil Price Information Service, says you need to look at prices over time to see “just how expensive the 2004-2008 run-up in prices was for the American consumer.”

Today’s national average gasoline price is $1.81 a gallon, which is down from $3.06 a gallon a year ago. “We are paying [as a country] more than $900 million less per day than we were in mid-July 2008, and we will pay about $500-million less per day than we did in December 2007, “ he said.

But, he notes, in 2006 the average price was $2.25 a gallon, a price level that ratcheted up from $1.14 a gallon, which was the average price back in 2003.

Bad for Investors

Oil prices are a critical economic barometer. And as demand continues to crater, falling energy prices signal there is no bottom yet in sight for the economy—or markets.

“Lower [energy] prices are not a positive in the near-term as it relates to investment decisions because it is signaling that the economic dent, the contraction we are going through is deeper than most people expected,” said U.S. Trust’s Hyzy.

In previous business-led recessions, lower prices of energy—a key input—would improve company profit margins. But companies are seeing lower demand for their products, which makes raising prices difficult, so profit margins are being squeezed even as energy costs decline.

Depressed energy prices also are undercutting profitability in the very sector [natural resources/energy] that has "dominated the growth of the S&P 500's profit cycle," Hyzy said.

“Now that has collapsed,” he added. “So that is sending a negative signal overall that if the one chief sector that has actually done well in the past two years is now also starting to pull back very, very sharply, then the overall S&P corporate earnings should pull back much worse than most people expected.”

Dangerous Temptations

Most analysts expect the new lower price range will prevail through 2009, and Hyzy predicts oil will drop to low $40 by the first quarter of the year. Crude is already falling below $50 a barrel.

“Prices are going to overshot to the downside as they overshot to the upside,” he said.

Behravesh is predicting oil will end 2009 at about $50-55 and then settle in the $70-80 range for the next couple of years after that.

The main reason for the oil price softness is that spare production capacity has soared in the face of collapsing demand, says Ruchir Kadakia, who heads global fundamental analysis for the Cambridge Energy Research Associates.

Global energy demand, projected by the International Energy Agency to grow by 2.1 million barrels a day during 2008, instead is expected to decline by several hundred thousand barrels.

As a result, spare capacity at the beginning of the year, was 2.2 million barrels per day.

That's represents about 2 percent of world demand—a very tight market.

Spare capacity is now approaching five million barrels, providing world energy markets with a critical psychological cushion.

“That’s the equivalent of taking Iran [its oil production] off the market,” says Kadakia. “It has permanently removed the geopolitical risk premium that has been in the market and it puts spare capacity at a level we have not seen since 2002.”

Another factor is the current financial deleveraging process, with hedge funds, which contributed considerable froth to energy markets, now facing redemption calls, he added.

The oil price collapse is also leading to exploration and production budget cuts, which could constrict future oil supplies.

“People generally make capex [capital expenditure] decisions three years out so production for 2009 and 2010 are very much in tact but if oil prices were to remain at depressed levels—the high $40 to $50 level [beyond 2010]—there is definitely significant risk to future productive capacity, which could catapult us back into $100 a barrel environment very quickly when demand does materialize,” says Kadakia.

Today’s cheap energy prices could also undermine initiatives to develop green technology, which Kadakia said will now depend more than ever on strong policy incentives.